Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Jacob de Tusch-Lec, manager of the Artemis Global Income Fund, explains how to invest given the many economic, geopolitical and policy risks that remain in today’s market.
The rally in cyclical ‘value’ stocks paused for breath in February, as investors took a more cautious tone and switched their attention back to defensive areas. In this article, Jacob de Tusch-Lec, manager of the Artemis Global Income Fund, explains how he has positioned the portfolio given the many economic, geopolitical and policy risks that remain.
The powerful rally in cyclical ‘value’ stocks and financials seen in the second half of last year – and which carried over into January, paused for breath in February. Although global equity indices crept higher, the gains tended to be led by more defensive areas. In this, the equities seemed to be following the more cautious mood evident in the bond market. Having risen sharply since the summer, yields on safe-haven government bonds, including 10-year US Treasuries, fell slightly on the month.
Yields on two-year German government bunds, meanwhile, hit new lows. On first view, that seems counter-intuitive: economic data from around the world remains strong and there are signs of inflation after a decade’s absence. In Europe, for instance, the composite Purchasing Managers' Index (PMI) hit its highest level since 2011 and inflation in Germany picked up. Yet despite this, bond investors aren’t fully buying into the vision of a world of stronger, more consistent economic growth and higher inflation.
Why Have European Bond Yields Fallen?
How to account for this fall in yields? More importantly, should equity investors worry? All the structural factors that support bond prices, such as the regulations enacted in the wake of the financial crisis obliging financial institutions to buy them – and the fear of investing in volatile assets – remain. At the same time, there is a sense that the balance of political risks has changed. The unpredictability of President Trump’s administration caused political risk premia to increase.
A similar dynamic was also at work in Europe. Although the prospect of Marine Le Pen becoming the next president of France – and endangering the future of the Eurozone – remains somewhat remote, the struggles of her opponents have added to that risk, even if only at the margin.
So, we don’t necessarily interpret lower bond yields as a sign of a slowdown in the economy. Instead we see them as a function of a shortage of ‘safe’ assets. German government bunds, for instance, are not traded on valuation but being held as insurance against negative ‘tail risk’ outcomes in Europe.
Paradoxically, it could also be the case that strong data on the US economy is contributing to fears of a slowdown. Might the US economy be in danger of overheating when, or if, Trump’s fiscal stimulus is applied? Strong data releases on the US economy – the number of Americans applying for first-time unemployment benefits recently touched a 44-year low – meant the market has increasingly come to accept not only that the Federal Reserve would likely increase base rates in March but that another two increases are possible this year.
Has the risk of the Fed making a policy mistake – encouraging it to act too aggressively to pre-empt inflation – increased? While a 50 basis point increase still seems rather unlikely, it is no longer beyond the realms of possibility. The mood has changed.
Value Stocks’ Lag Impacts Returns
From the fund’s perspective, that economically sensitive ‘value’ stocks fell slightly out favour meant that it lagged the market’s rise in February, snapping a strong run of outperformance reaching back to last summer.
However, mining companies tended to report sharp increases in earnings. BHP Billiton (BLT), reported a 65% increase in underlying earnings and, signalling management’s confidence, increased its dividend. Yet the market greeted this news – and news like it – with little more than a shrug. In part, this may be a case of reality belatedly catching up with the transformation in expectations that took place in the second half of last year.
At the same time, there does seem to be a feeling in some quarters that this might be ‘as good as it gets’ for the global economy. Lower bond yields are helping to reinforce that notion and making some investors pause before committing more capital to more cyclical areas.
How to Invest in Today’s Market
We acknowledge that the synchronised expansion across all regions of the global economy won’t last forever. We also see a risk the Fed moves too fast on rates – and we admit we have no idea what President Trump might do next. A technical term for being afraid of politicians’ actions is ‘policy risk’.
We now have monetary policy risk; that the Fed tightens too much or too quickly, fiscal policy risk; that Trump’s fiscal irresponsibility leads to higher bond yields, and geopolitical risks; as Trump changes US military imperatives, dangerous situations are emerging in Asia and in the Middle East.
At the same time, data shows strong growth continuing while news from, still somewhat cheap, cyclical stocks remains extremely positive. It seems wise not to be positioned too narrowly for any one particular outcome.
Disclaimer
The views contained herein are those of the author(s) and not necessarily those of Morningstar. If you are interested in Morningstar featuring your content on our website, please email submissions to UKEditorial@morningstar.com
